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Report to Congressional Requesters:

April 2004:

MINERAL REVENUES:

Cost and Revenue Information Needed to Compare Different Approaches for 
Collecting Federal Oil and Gas Royalties:

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-448]:

GAO Highlights:

Highlights of GAO-04-448, a report to Representative Nick J. Rahall, 
Ranking Minority Member, House Committee on Resources, and 
Representative Carolyn B. Maloney 

Why GAO Did This Study:

In fiscal year 2003, the federal government collected $5.6 billion in 
royalties from oil and gas production on federal lands. Although most 
oil and gas companies pay royalties in cash, the Department of the 
Interior’s Minerals Management Service (MMS) has the option to take a 
percentage of the oil and gas produced and sell this product—known as 
“taking royalties in kind (RIK).” MMS has taken royalties in kind 
continuously since 1998 with the goal of achieving administrative 
savings while maintaining revenue. GAO attempted to (1) quantify the 
administrative savings that may be attributable to the RIK sales and 
(2) compare the sales revenues from RIK sales to what would have been 
collected in cash royalty payments.

What GAO Found:

Although data on administrative savings are limited, there are 
substantial audit savings attributable to RIK sales, but there are no 
quantified savings in the overall administration of royalty 
collections. MMS has anticipated savings in auditing and litigation 
expenses. While MMS data showed that auditing costs for RIK sales were 
less than auditing costs for cash sales on a per lease basis, MMS 
redirected the resources it saved to auditing additional leases. At 
this time, MMS cannot quantify the benefit from additional auditing. 
The costs of litigation, which the Solicitor’s Office in the Department 
of the Interior performs for MMS, are not tracked. However, officials 
with the Solicitor’s Office were unable to attribute any savings in 
litigation to the increased use of RIK and said that future litigation 
costs are difficult to predict. Finally, MMS must weigh these benefits 
against additional costs required to conduct RIK sales.

Despite limitations in MMS’s analyses and revenue data that prevented a 
more comprehensive assessment of all RIK sales, our estimate of the 
revenue impacts from RIK sales in three areas indicates a mixed 
performance. Specifically, RIK oil sales in Wyoming increased revenues 
by 2.6 percent, for a gain of $967,000 on sales of $37 million. RIK oil 
sales in the Gulf of Mexico decreased revenues by $7.2 million, for a 
loss of 5.5 percent on sales of $131 million. RIK gas sales in the Gulf 
increased revenues by $4 million, for a gain of 2 percent on revenues 
of $210 million. However, these sales only represent 11 percent of the 
gas and 57 percent of the oil that MMS took in kind from inception of 
the pilots through November 2003. MMS does not analyze all sales 
because there is no requirement to do so, staff considers existing 
information on sales sufficient, few staff are assigned to analyzing 
sales, and MMS management has a lengthy review process for finalizing 
sales analyses.

Actual and Projected RIK Gas Sales in the Gulf of Mexico: 

[See PDF for image]

[End of figure]

What GAO Recommends:

GAO reported on MMS’s RIK Program in 2003 and recommended that MMS 
identify and acquire key information to monitor and evaluate the RIK 
Program prior to expanding the program further. While MMS has made some 
progress, it has yet to implement these recommendations. Should the 
Congress seek more assurance of the level of success of the RIK 
Program, it might consider directing MMS to establish a systematic 
evaluation of the revenue impacts of all future sales and to quantify 
overall changes in the administration of royalty collections. In 
commenting on the draft report, Interior generally agreed with GAO’s 
observations.

www.gao.gov/cgi-bin/getrpt?GAO-04-448.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Jim Wells at (202) 
512-3841 or wellsj@gao.gov.

[End of section]

Contents:

Letter: 

Results in Brief: 

Background: 

Savings in Auditing RIK Occur, but Overall Impact on Royalty 
Administration Costs Cannot Be Completely Quantified: 

The Revenue Impact of RIK Sales Is Mixed: 

Conclusions: 

Matters for Congressional Consideration: 

Agency Comments and Our Evaluation: 

Appendixes:

Appendix I: Objectives, Scope, and Methodology: 

Wyoming Oil: 

Gulf of Mexico Oil: 

Gulf of Mexico Gas: 

Other Factors May Affect Revenue Analysis: 

Appendix II: Comments from the Department of the Interior: 

GAO Comments: 

Appendix III: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Acknowledgments: 

Figures: 

Figure 1: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected Asphaltic Properties Subsequently Included in RIK Sales: 

Figure 2: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected General Sour Properties Subsequently Included in RIK Sales: 

Figure 3: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected Sweet Properties Subsequently Included in RIK Sales: 

Abbreviations: 

ABC: activity-based cost:

DOE: Department of Energy:

GAO: General Accounting Office:

MMBtu: one million British thermal units:

MMS: Minerals Management Service:

MOPS: Matagorda Offshore Pipeline System:

MRM: Minerals Revenue Management:

NYMEX: New York Mercantile Exchange:

RIK: royalty in kind:

SPR: Strategic Petroleum Reserve:

Letter April 16, 2004:

The Honorable Nick J. Rahall: 
Ranking Minority Member: 
Committee on Resources: 
House of Representatives:

The Honorable Carolyn B. Maloney: 
House of Representatives:

In fiscal year 2003, the Department of the Interior's Minerals 
Management Service (MMS) collected about $5.6 billion in royalties from 
oil and gas production on federal lands. MMS traditionally accepts the 
federal government's oil and gas royalties in cash. Under the Mineral 
Leasing Act of 1920 and the Outer Continental Shelf Lands Act, MMS also 
has the authority to take a portion of the actual oil and gas produced, 
referred to as "taking royalties in kind." MMS then sells this oil and 
gas to the highest bidders at competitive auctions. MMS established 
Royalty-in-Kind (RIK) pilot sales with the intent of testing whether 
MMS can (1) decrease the cost of administering royalties and (2) 
maintain or increase royalty revenues. MMS began to evaluate the use of 
federal royalty oil as an alternative to cash royalty payments through 
a series of pilot sales in Wyoming beginning in 1998. In addition, MMS 
has conducted pilot sales for gas and oil in the Gulf of Mexico. We 
estimate that revenue from RIK pilot sales was about $682 million in 
fiscal year 2003. Based on MMS estimates for further expansion of RIK 
sales, MMS could be collecting between $1.5 billion and $2.5 billion 
per year in revenue from RIK pilot sales by 2008.

To address MMS progress toward a more systematic evaluation of MMS's 
RIK efforts, you asked us to (1) quantify any savings in administering 
royalty collections that are attributable to the RIK pilots and (2) 
compare sales revenues from RIK pilots to what would have been 
collected under cash royalty payments.

In responding to the objectives, we discussed the RIK sales program 
with MMS officials and oil and gas marketers who are active in Wyoming 
and the Gulf of Mexico, where MMS has conducted almost all of its RIK 
pilot sales. We initially reviewed documents analyzing RIK sales and 
the costs to administer these sales. However, we found at the start of 
our review that MMS had only released two draft reports that analyzed 
the impact of RIK sales, and these reports and other informal studies 
only addressed the revenue impacts associated with 9 percent of the 
royalty oil sold through July 2002 and about 44 percent of the royalty 
gas sold through March 2002. The reports remained in draft until 
approved by management in March 2004. While the two studies asserted 
that RIK sales produce administrative savings, the studies did not 
conclusively quantify any savings. Given the nature of MMS's limited 
analysis of administrative cost and revenue impacts, we attempted to 
address the objectives by acquiring and analyzing additional MMS data. 
However, in the course of our analysis, we found that sufficiently 
detailed administrative cost information necessary to compare RIK to 
cash royalties does not exist, leaving us unable to completely assess 
the administrative impacts.

In evaluating the revenue impact of RIK sales, we obtained royalty data 
from MMS's financial data system. However, this system was designed to 
collect and disburse revenues and not to specifically analyze the 
revenue impacts of RIK sales; therefore it was not suitable for doing a 
comprehensive evaluation of the RIK sales. In addition, some erroneous 
and missing data required time-consuming inspections of the royalty 
data to ensure their reliability and integrity. As a result, we were 
only able to assess the revenue impacts in case studies representing 
parts of three RIK pilot sales areas: Wyoming oil, Gulf of Mexico oil, 
and Gulf of Mexico natural gas. The sales we analyzed represented about 
57 percent of the royalty oil and 11 percent of the royalty gas MMS 
took in kind from inception of these pilots through November 2003. We 
performed significance tests on the results of our case studies and 
found them to be statistically significant at the 5 percent level. 
However, it was not possible to project the total revenue impact of all 
the RIK pilot sales from these case studies because the difference 
between RIK revenues and cash royalty revenues can vary greatly over 
time and because the case studies are not representative samples of all 
RIK sales. In addition, we were unable to obtain data that would have 
enabled us to measure the effects of audits on revenues from RIK and 
cash sales, which adds uncertainty to our estimates in the case 
studies. Therefore, we are unable to determine conclusively how well 
the RIK pilot sales have done compared to what would have been expected 
from cash sales over the long term.

We conducted our work from February 2003 through March 2004 in 
accordance with generally accepted government auditing standards. For a 
more detailed discussion of the scope and methodology of our review, 
see appendix I.

Results in Brief:

There are substantial administrative savings in auditing royalty 
collections that are attributable to the RIK pilots, but there are no 
quantified savings in the overall administration of royalty 
collections. MMS has stated that the RIK pilots should create savings 
primarily by reducing the costs of auditing royalty payments and by 
decreasing overall litigation. RIK royalty auditing costs are 
substantially less than cash royalty auditing costs on a per-lease 
basis, but MMS simply redirected any resources it saved to auditing 
more cash payments. Although more audits of these cash payments could 
result in higher revenue collections if the audits identified royalty 
underpayments, MMS is not currently able to determine this benefit 
because the auditing of cash payments takes several years to complete. 
Similarly, the Department of the Interior's Solicitor's Office could 
not identify any change in the amount of litigation attributable to the 
RIK pilots or predict the extent to which RIK would affect its future 
litigation workload. MMS did incur other administrative costs under RIK 
that it would not have incurred by accepting cash royalty payments. For 
example, it incurred $1.7 million in direct costs to conduct the RIK 
pilot sales during fiscal year 2003 and one-time costs of $13 million 
to purchase information systems that, among other things, were intended 
to bill, collect, and report revenues from the RIK pilots.

Our analysis of the revenue impacts from three case studies of RIK 
pilots indicated a mixed performance when compared to cash royalty 
payments. Specifically, we estimated that (1) RIK sales in Wyoming 
increased revenues by about 2.6 percent, for a gain of $967,000 on 
sales of about $37 million; (2) a 6-month oil sale in the Gulf of 
Mexico decreased revenues by 5.5 percent, for a loss of $7.2 million on 
sales of about $131 million; and (3) natural gas sales in the Gulf of 
Mexico increased revenues by about 2 percent, for an estimated gain of 
about $4 million on sales of about $210 million. These sales 
represented about 11 percent of the gas and 57 percent of the oil that 
MMS took in kind from inception of the pilots through November 2003. 
Limitations in MMS's data and a lack of MMS analyses of RIK sales 
precluded us from comprehensively analyzing the revenue impact of more 
RIK sales in a timely manner. Currently, MMS is not required to analyze 
sales or document them, the staff responsible for conducting sales 
considers the information on sales results sufficient, few staff are 
assigned to analyzing sales, and MMS management has not placed a 
priority on the time-consuming review of sales results.

In January 2003, we reported to the Congress that MMS had not developed 
sufficient management control over its RIK sales, including the 
collection of the data necessary to quantify the revenue impacts and 
the administrative savings attributable to the RIK program.[Footnote 1] 
In our report, we recommended that the Secretary of the Interior 
instruct the appropriate managers in MMS to identify and acquire key 
information to monitor and evaluate the RIK program prior to expanding 
the program. We recommended that such information include the revenue 
impacts of all RIK sales and the administrative costs and savings 
attributable to RIK. MMS generally agreed with our recommendations and 
emphasized their current efforts and future plans to improve the 
evaluation of RIK. We recognized MMS's progress in establishing 
management control and documenting the results of its RIK sales. 
However, as RIK sales have continued to grow, it is still difficult to 
completely quantify the administrative cost and revenue impact of the 
RIK program. As MMS looks to continue to expand the use of RIK, we are 
suggesting that if the Congress wants to ensure a systematic and timely 
evaluation of RIK efforts, the Congress may want to consider directing 
MMS to conduct an evaluation of all future RIK sales and to quantify 
any changes in the administrative cost and revenue impact on royalty 
collections as a result of RIK.

Background:

In general, royalty rates for onshore federal oil and gas leases are 
12-1/2 percent of the value of the oil and the gas produced, whereas 
royalty rates for offshore leases are generally 16-2/3 percent. MMS 
also administers programs under which royalties are reduced or 
suspended to encourage exploration and production. The administration 
of cash royalty payments has been challenging for MMS. MMS relies upon 
royalty payors to self-report the amount of oil and gas they produce, 
the value of this oil and gas, and the cost of transportation and 
processing that they deduct from cash royalty payments. With 22,000 
producing leases and often several companies paying royalties on each 
lease each month, the auditing of these cash royalty payments has 
become a formidable task. In addition, payors and MMS often disagree 
over the value of the oil and gas and the transportation and processing 
deductions, leading to time-consuming and costly appeals and litigation 
for those disagreements that they cannot resolve. MMS claims that 
compared to cash royalty payments, RIK can substantially simplify the 
administration of royalties because it reduces these disagreements and 
the time that MMS must spend resolving them. While RIK offers the 
promise of simplified administration, MMS must also consider the 
revenue impact of RIK. The Mineral Leasing Act of 1920 and the Outer 
Continental Shelf Lands Act authorize taking royalties in kind. These 
two acts directed the Secretary of the Interior to obtain fair market 
value for the oil and gas taken in kind.[Footnote 2] The Outer 
Continental Shelf Lands Act defined "fair market value" as the average 
unit price for the mineral sold either from the same lease or, if such 
sales did not occur, in the same geographic area. Moreover, the fiscal 
years 2001 through 2004 Appropriation Acts for Interior and related 
agencies directed MMS to collect at least as much revenue from RIK 
sales as MMS would have collected from traditional cash royalty 
payments.

In recent years, MMS conducted three major RIK pilots involving (1) oil 
in Wyoming, (2) oil in the Gulf of Mexico, and (3) natural gas in the 
Gulf of Mexico. For oil in Wyoming, MMS has taken royalties in kind 
since October 1998. Although the amount of royalty oil that MMS takes 
in kind in Wyoming is less than 1 percent of all federal royalty oil, 
MMS has gained valuable experience during these sales. MMS has also 
taken royalty oil in kind in the Gulf of Mexico in two 6-month sales 
between November 2000 and March 2002. Unlike in Wyoming, the amount of 
royalty oil that MMS took in the Gulf approached 20 percent of all 
federal royalty oil during the second 6-month sale from October 2001 
through March 2002. MMS's RIK oil pilot in the Gulf was put on hold 
when the president directed that MMS use royalty oil to fill the nearby 
Strategic Petroleum Reserve (SPR). Finally, for natural gas in the Gulf 
of Mexico, MMS has consistently taken natural gas in kind since 
December 1998. MMS currently takes about 19 percent of total federal 
royalty gas in pilots conducted in the Gulf of Mexico, and this program 
continues to grow.

Savings in Auditing RIK Occur, but Overall Impact on Royalty 
Administration Costs Cannot Be Completely Quantified:

While there are substantial administrative savings in auditing royalty 
collections that are attributable to the RIK pilots, there are no 
quantified savings in the overall administration of royalty 
collections. MMS's overall budget to administer royalties has declined 
slightly as MMS increased the use of RIK, but the development of many 
other changes in royalty administration during the same time makes it 
difficult to assess the relative impact of RIK. MMS only began 
collecting detailed administrative cost information starting in fiscal 
year 2003, so it is not possible to attribute costs to the different 
royalty administration activities before then. MMS's development of a 
more specific cost information system in 2003 may help with future 
impact assessments, but will not allow any comparison to the past. MMS 
claims that the administrative cost savings from using RIK comes 
primarily from a reduction in audit and litigation activities that 
would have occurred under cash royalty collections. Information 
collected by MMS starting in 2003 has supported MMS's assertion that 
RIK pilots can create savings by reducing the costs of auditing royalty 
payments. While MMS has redirected auditing resources it saved to 
auditing more cash payments, it is not yet able to determine the 
benefit of this increased audit effort on overall royalty collection. 
Regarding litigation savings, no litigation cost information has been 
collected nor have any savings been identified. Finally, these 
potential savings must be weighed against additional specific costs 
that would otherwise not be incurred under cash royalties, such as 
operating costs in fiscal year 2003 of $1.7 million to conduct the RIK 
sales. MMS also incurred a capital investment of $13 million to 
purchase information systems.

MMS's Budget to Administer Royalty Collections Has Declined Slightly, 
but the Impact of RIK Is Not Clear:

In October 2001, MMS reorganized and created the Minerals Revenue 
Management organization (MRM) within MMS to collect, disburse, and 
audit royalty revenues. Since its creation, MRM's budget has declined 
by about 7 percent, from $86.5 million in fiscal year 2002 to $80.4 
million in fiscal year 2004. Approximately 41 percent of MRM's budget 
over this period supported financial management, including the 
collection and disbursement of royalty revenues. Nearly all of the 
remaining 59 percent of the budget supported compliance asset 
management, a major function of which is the auditing of oil and gas 
royalty revenues. Budget documents indicate that MRM has maintained 
about 572 full-time personnel from fiscal years 2002 through 2004, of 
which 184 were assigned to financial management and 388 were assigned 
to compliance asset management. An official within the Department of 
the Interior added that the actual number of employees on board was 558 
in 2004, with some of this difference due to a decrease in the number 
of personnel assigned to compliance asset management. Within compliance 
asset management is the RIK Office that oversees RIK pilot sales, the 
Small Refiners Program, and the filling of the SPR.

Other developments in the administration of royalty collection have 
made it difficult to attribute changes in the MRM budget to RIK 
activities. Whereas RIK sales significantly change the processes for 
collecting royalty revenues, other developments, including the 
substantial change in the duties of the personnel responsible for 
auditing oil and gas revenues and for ensuring compliance with 
applicable rules and regulations, have ultimately affected the way MMS 
deploys its personnel--a major component of MRM's budget. For example, 
in June 2000 MMS implemented new oil valuation regulations that provide 
more specific guidance on what prices companies must report to MMS on 
the sales of oil to their affiliates, and this should decrease 
discrepancies between MMS auditors and royalty payors. Similarly, MMS's 
increased willingness to write formal agreements on these prices is 
also expected to decrease such disagreements. The change in the way MMS 
audits oil and gas revenues since its reorganization is also expected 
to decrease its workload. For example, MMS auditors no longer routinely 
compare all production volumes reported by the operators of oil and gas 
leases against all sales volumes reported by royalty payors to search 
for possible underpayments. Instead, MMS auditors now perform this 
activity on a case-by-case basis as needed. MMS auditors are also 
increasingly selecting the property as the entity to audit rather than 
selecting an individual company. Finally, when MMS does select a 
company to audit, there are fewer companies to select because of the 
recent mergers of the large oil and gas companies.

Prior to fiscal year 2003, MMS lacked the necessary data to 
conclusively quantify the difference in administrative costs under 
different royalty collection methods. Under Interior's agencywide 
initiative, MMS implemented an activity-based cost (ABC) management 
system in fiscal year 2003. The system identifies specific work 
activities in order to measure their costs, monitor and evaluate 
program performance and results, and improve the way MMS does its work. 
In essence, MMS personnel record the hours spent on specific work 
activities, such as RIK audits, and convert these hours into labor 
costs. These labor costs are then added to nonlabor costs, such as 
travel and materials costs, to produce total direct costs for the 
identified work activities. MMS has captured the costs of the work 
activities included in the collection and auditing of royalty revenues 
during fiscal year 2003. Such information may help MMS compare the 
costs of administering the RIK sales to the costs of administering cash 
royalty collections; however, there is no way to make this comparison 
prior to fiscal year 2003.

RIK Reduces Audit Costs, But Overall Impact on Royalty Collection Is 
Not Quantified:

According to MMS, the auditing and compliance effort is significantly 
reduced under RIK because MMS and the RIK purchaser agree to a 
contractual price before the sale and because transportation deductions 
are no longer an issue when MMS sells the oil or gas at the lease. MMS 
further explained that auditing RIK leases can be done within as little 
as 120 days after the sale because it has all the necessary price 
information at that time, while up to 3 years transpire before MMS 
initiates an audit of cash royalty payments. During such cash royalty 
audits, MMS personnel must physically collect and inspect collaborative 
pricing and transportation documents, often at the payors' offices, 
while similar pricing information for RIK sales is instantly available 
in MMS's information systems.

The data from MMS's newly implemented ABC management system does 
support MMS's assertion that the auditing of certain RIK sales revenues 
is less costly on a per-lease basis than the auditing of comparable 
cash royalty payments. A review of the auditing and compliance costs 
for oil and gas leases in the Gulf of Mexico and Wyoming--two locations 
in which MMS received both cash and in-kind royalty payments during 
fiscal year 2003--showed that the costs to audit cash sales per lease 
were substantially higher than the costs to audit in-kind royalties in 
both areas. In the Gulf of Mexico, MMS reported spending $6,765,000 to 
audit cash sales from 242 oil and gas leases, or $27,956 per lease, 
while spending $458,000 to audit all 297 gas leases included in the RIK 
pilot sales, or $1,542 per lease. Similarly, MMS reported spending 
$820,000 to audit cash royalties from 912 oil and gas leases in 
Wyoming, or $899 per lease, while spending $38,000 to audit all 580 RIK 
oil leases in Wyoming, or $66 per lease.

While the ABC data suggest that the auditing costs for RIK sales 
revenues are less than the auditing costs for cash royalty payments, 
this difference does not necessarily mean that MMS is spending less 
money as it moves more leases into its RIK sales. MMS explained that 
instead of decreasing its audit budget, it has used these freed-up 
resources to audit additional cash royalty payments that it would not 
have otherwise audited. In addition, MMS has stated that auditing 
additional cash royalty payments could result in the collection of 
additional revenues. For fiscal year 2000, the latest year for which 
audit data are available, MMS reported that its audit activities, 
together with state and tribal audits of federal royalty revenues, 
generated about $219 million (or 5 percent) on royalty revenues of 
about $4.6 billion. However, MMS will not know the results of auditing 
additional cash royalty payments for several years because it takes 
time to select leases for audit, conduct the audits, and resolve 
related appeals and litigation. In the future, it is possible that MMS 
may experience different rates of revenue increase, either upwards or 
downwards, as it expands its audit coverage because of the different 
leases it selects for audit.

Litigation Costs Are Not Tracked:

MMS's new ABC system provided costs associated with taking royalties in 
kind during fiscal year 2003, but it did not capture the costs 
associated with specific types of litigation performed by others for 
MMS. Litigation sometimes arises after MMS or state and tribal auditing 
efforts identify a discrepancy that cannot be resolved by MMS and the 
payors. Such discrepancies commonly involve the value of oil and gas or 
the costs of transporting this oil and gas to market. MMS has 
maintained that the taking of royalties in kind reduces litigation. 
However, the savings that could result from avoiding litigation cannot 
be quantified by MMS because MMS does not conduct the litigation. 
Instead MMS relies primarily upon the Department of the Interior's 
Solicitor's Office, which does not track specific types of litigation 
costs for MMS. Officials in the Solicitor's Office reported that since 
fiscal year 1999, between two and four of their attorneys worked full-
time on MMS royalty issues. In addition, these officials said that 
attorneys within the Department of Justice represent MMS in court. 
Officials in the Solicitor's Office could not attribute any decrease in 
litigation to an increase in the use of RIK. They also stated that the 
nature of the royalty litigation could change as a result of RIK; while 
litigation over valuation and transportation deductions may decrease, 
litigation over RIK contracts and discrepancies over volumes sold may 
increase. They also cautioned that future litigation over 
administrative decisions and rule making is impossible to predict. 
Finally, regardless of the volume of RIK sales, they cautioned that as 
long as MMS receives some cash royalty payments, there would always be 
the potential for litigation on valuation issues and transportation 
allowances.

RIK Sales Require Additional Costs Not Incurred When Collecting Cash 
Royalties:

The administration of the RIK pilot sales includes additional 
activities that are not necessary when accepting cash royalty payments 
and therefore add to the cost of collecting royalties in kind. Such 
activities include identifying properties from which to sell oil and 
gas, calculating minimum acceptable bids, awarding and monitoring 
contracts, billing purchasers, negotiating transportation rates, and 
reconciling discrepancies in volumes. In fiscal year 2003, MMS's 
preliminary ABC data showed direct costs of $1.7 million to conduct 
activities for the RIK pilot sales that it would not have incurred had 
it accepted cash royalty payments.[Footnote 3] Of this $1.7 million, 
MMS reportedly spent $475,000 to identify properties, calculate minimum 
acceptable bids, and conduct sales; $464,000 to market the royalty oil 
and gas; $176,000 to monitor the credit worthiness of purchasers; 
$496,000 for auditing leases and reconciling volumes; and $127,000 for 
policy compliance and legal support.

MMS also incurred one-time costs of more than $13 million to acquire 
three information systems, part of whose functions are to bill, 
collect, and report on revenues from the RIK pilots. When fully 
implemented, these systems may help address the management control 
weakness that we previously identified involving the manual entry of 
data into unlinked computer spreadsheets.[Footnote 4] The first of 
these systems, the gas information system, is wholly dedicated to the 
administration of the RIK gas pilot sales and cost $7.3 million. 
Implemented in January 2003, the system automates the billing, 
collecting, and reporting functions. MMS's second system, the liquids 
information system, cost almost $5 million and was implemented in June 
2003. Like the gas system, it is designed to automate the billing, 
collecting, and reporting functions, but unlike the gas system it is 
not wholly dedicated to the RIK pilot sales, but also supports the 
Small Refiners Program and the filling of the SPR. MMS's third system, 
the Risk and Performance Management System, cost about $0.9 million and 
is designed to measure the results of the RIK gas sales and the Small 
Refiners Program for periods during 2003. In addition, MMS's 
preliminary ABC data shows that MMS incurred direct costs of $682,000 
in fiscal year 2003 to develop and maintain these information systems. 
MMS will also incur additional costs in future years to operate and 
maintain these systems.

The Revenue Impact of RIK Sales Is Mixed:

Our analysis of sales in three RIK pilots indicates a mixed performance 
when comparing RIK sales revenue to what might have been collected 
under cash royalty payments. Specifically, (1) RIK sales in Wyoming 
increased revenues by about 2.6 percent, for an estimated gain of 
$967,000 on sales of about $37 million; (2) a 6-month oil sale in the 
Gulf of Mexico decreased revenues by 5.5 percent, for an estimated loss 
of $7.2 million on sales of about $131 million; and (3) natural gas 
sales in the Gulf of Mexico produced more revenues than would have been 
collected from cash royalty payments--an increase of about 2 percent, 
for an estimated gain of $4 million on revenues of $210 million. These 
sales represented about 11 percent of the gas and 57 percent of the oil 
that MMS took in kind from inception of the pilots through November 
2003. Our attempts to review the revenue impact of more RIK sales were 
precluded by specific limitations in MMS financial data and the 
availability of only two independent MMS draft reports.[Footnote 5] As 
we observed in our January 2003 report, MMS continues to expand its RIK 
pilots without analyzing and documenting the revenue impacts of all its 
RIK sales. MMS is making some progress in this area, but still has not 
demonstrated that it has received fair market value, or at least as 
much as it would have received in cash royalty payments.

RIK Oil Sales in Wyoming Increased Revenues by About 2.6 Percent:

MMS chose to conduct its first RIK oil sales in Wyoming because of the 
state's active oil markets and the cooperative spirit of state 
officials. MMS offered for sale the federal government's royalty share 
of oil together with the state of Wyoming's royalty oil that was for 6-
month periods beginning in October 1998.[Footnote 6] Bidders offered a 
fixed amount of money either more or less than published market prices, 
such as Wyoming posted prices, Canadian posted prices, and the oil 
futures contract on the New York Mercantile Exchange (NYMEX).[Footnote 
7] The winning bidders, which included companies that market, refine, 
transport and/or produce oil in Wyoming and adjacent states, accepted 
delivery of the oil at the lease. Although MMS's RIK sales in Wyoming 
accounted for only about 1 percent of total federal royalty oil, MMS 
acquired significant knowledge on how to conduct sales and market oil 
onshore. For example, MMS determined that companies more commonly bid 
on royalty oil from properties that are connected to pipelines and 
prefer flexibility in choosing a specific price upon which to base 
their bid. In addition, MMS learned in 2002 that it was not profitable 
to transport the volumes from many scattered leases to one central 
location for sale.

In a draft report issued in March 2001, updated in June 2002, and 
finalized in March 2004, MMS estimated that it received slightly more 
revenue in its first three RIK sales than it would have received in 
cash royalty payments. Specifically, MMS reported that it collected 
$810,000 more from RIK sales than it would have received in cash 
royalty payments, or an increase of about 2.9 percent on sales of 
$27.66 million from October 1998 through March 2000. MMS based its 
conclusion on a comparison of winning RIK bids to severance taxes that 
producers reported and paid to the state of Wyoming. State severance 
taxes are calculated as a percentage of the value of all oil that 
companies sell, regardless of whether the oil is produced from federal, 
state, or private lands. Because the state of Wyoming's oil valuation 
statutes are similar to how the federal government values oil, MMS 
assumed that the price that companies reported for state severance 
taxes on RIK properties was equal to the price that the government 
would have received in cash royalty payments. However, MMS did not 
demonstrate that the average sales prices for cash royalty payments 
were equal to the average sales prices used to calculate Wyoming 
severance taxes, initially creating some uncertainty about MMS's 
revenue calculations.

To address the uncertainty in MMS's assumption about the relationship 
between cash royalty payments and severance tax prices, we analyzed the 
relationship. For nine federal properties[Footnote 8] that accounted 
for about 47 percent of the oil that MMS sold in Wyoming during the 
first seven RIK sales, we compared Wyoming severance tax data with 
MMS's financial data for the 33-month period prior to the RIK sales and 
concluded that Wyoming severance tax prices are a reasonable proxy for 
cash royalty payments. Therefore, based on Wyoming severance tax data, 
we estimated that MMS collected $967,000 more from the RIK sales from 
October 1998 through March 2002 than it would have collected in cash 
royalty payments--an increase of about 2.6 percent on sales of about 
$37 million. The results of our analysis of selected Wyoming RIK sales 
are consistent with MMS's conclusion that the RIK sales that it 
analyzed resulted in slightly more revenue that it would have realized 
if it had accepted cash royalty payments. A more detailed discussion of 
our analysis appears in appendix I.

Six Months of RIK Oil Sales in the Gulf of Mexico Decreased Revenues by 
About 5.5 Percent, But Long Term Impacts Could Differ:

Although MMS has a long-standing history of selling royalty oil through 
the Small Refiners Program, MMS did not sell offshore royalty oil 
directly to other qualified purchasers until November 2000. MMS sold, 
through two separate 6-month sales, up to 20 percent of the federal 
government's royalty share of oil in the offshore Gulf of Mexico to all 
purchasers meeting predetermined financial qualifications, whether 
they were small refiners, large refiners, producers, or 
marketers.[Footnote 9] Winning bidders offered a fixed amount of money 
that was more than or less than a formula based on one of two widely 
published oil prices--Koch's published price for West Texas 
Intermediate oil in the first sale and the NYMEX futures contract in 
the second sale. During the first sale, MMS offered about 39,000 
barrels of oil per day, but awarded contracts for only about 7,600 
barrels per day. Only two companies submitted bids. MMS attributed the 
lack of interest to the delivery points for the oil being at market 
centers onshore rather than offshore near the lease. During the second 
sale, which commenced in October 2001, MMS offered and awarded 
approximately 48,000 barrels of oil from six major pipeline systems. 
Nearly all of the oil consisted of two types, referred to as the Mars 
and Eugene grades, produced in water depths up to about 4,000 feet. The 
delivery point for the oil was offshore near the lease, and competition 
was robust. MMS terminated the Gulf RIK oil pilots after the second 
sale when ordered by a Presidential directive to transfer oil from 
these properties to the SPR.

As of July 2003, MMS had not evaluated the revenue impacts of either 
sale. Because of the larger amount of oil sold during the second sale, 
we chose to analyze this sale and estimated that MMS received about 
$7.2 million less in revenues than it would have received had it 
accepted cash royalty payments--a 5.5 percent loss on sales of about 
$131 million. We selected 13 of the 26 leases included in the second 
sale that collectively accounted for about 89 percent of the oil 
offered and sold. For the 16-month period prior to the start of the 
second oil sale, we compared the average monthly sales price for oil 
from each lease to the price as prescribed by MMS's oil valuation 
regulations for sales between affiliated parties (transactions not at 
arm's-length).[Footnote 10] We then computed a weighted average 
difference in the monthly prices for the entire 16-month period and 
assumed that this weighted average difference would have persisted over 
the 6-month RIK sales period had royalties been paid in cash. A 
detailed explanation of our analysis appears in appendix I.

Because revenue from RIK sales and from cash sales can differ 
considerably in any given month, a longer period of evaluation is 
needed to determine whether a specific type of RIK sales can generate 
at least as much royalty revenue as cash sales. The reason that RIK and 
cash sales revenues differ month to month is that they are generally 
based on different sets of market prices. For example, the formula that 
MMS used to award RIK bids in the second Gulf of Mexico sale differs 
from the formula prescribed in the oil valuation regulations primarily 
in two ways: (1) the bidding formula relies on prices from a period 
that is almost a month earlier than that prescribed by the oil 
valuation regulations, thereby creating a timing difference and (2) the 
bidding formula relied on an adjustment to NYMEX futures price, 
referred to as "the roll." The roll is an adjustment that compensates 
for differences in oil futures prices for subsequent months. If futures 
prices for the next three trade months trend downward, the roll is a 
positive adjustment. If futures prices trend upward for the next three 
trade months, the roll is a negative number. Rising oil futures prices 
that accompanied uncertainty in the financial markets after the 
September 11 terrorist attacks resulted in generally lower-than-
anticipated RIK royalties caused by the timing differential and a 
negative roll, thereby contributing significantly to the negative 
performance of the second sale.

MMS officials agree that a 6-month term is an insufficient period of 
time during which to evaluate a sales methodology. Specifically, MMS 
added that it had intended to continue the oil sales in the Gulf of 
Mexico but that the President directed that royalty oil be used to fill 
the SPR, and royalty oil from the leases included in the pilot sales 
was the only feasible source. Although MMS generally agrees with the 
magnitude of the revenue impact that we identified during the 6-month 
period of the second sale, MMS believes that we should have examined a 
longer period of time, even though the oil that was sold during this 
sale was thereafter transferred to the SPR. After learning of our 
analysis, MMS conducted its own evaluation of many of the same leases. 
MMS combined the results of the 6-month second sale with the following 
12 months during which oil from these same leases was transferred to 
the SPR. MMS estimated that during this combined 18-month period, its 
sales methodology increased revenues by $4.9 million. This estimate, 
however, does not mean that MMS collected $4.9 million more than it 
would have collected in cash royalty payments. MMS's estimate is based 
on combining cash collections from RIK sales in the first 6 months with 
market index prices at the time that MMS transferred the oil to the 
Department of Energy (DOE) for filling of the SPR. MMS estimated that 
it lost $6 million in cash during the first six months and that the 
value of the oil transferred to DOE was $10.9 million more than it 
would have received in cash royalties had the RIK pilot sales continued 
for the next 12 months.

We do not believe that MMS's evaluation of the SPR program is 
necessarily indicative of how the RIK program would have performed had 
it been allowed to continue. The SPR program does not generate royalty 
income for the federal government in the same way as the RIK program 
does. In the SPR program, the royalty oil, or an equivalent amount from 
another source, is pumped into the reserve, and revenues will only be 
generated upon its removal and sale at some unspecified period in the 
future. In addition, the data that MMS used in estimating the revenue 
impacts of its Gulf of Mexico oil sales was problematic in several 
ways. First and most important, MMS did not adjust its revenue estimate 
by quality bank adjustments. Quality bank adjustments are either 
positive or negative adjustments to sales revenues that pipeline 
companies compute because the royalty oil is of either better or worse 
quality than the average quality of oil in the pipeline. Payors either 
add or subtract these adjustments from both their cash and in-kind 
royalty payments to MMS. Quality bank adjustments can be substantial--
during the second RIK sale, they lowered MMS's revenues on the leases 
we examined by $2.5 million. Second, MMS did not use the actual 
transfer volumes to the SPR in its financial database, opting instead 
to use volumes recorded in its production database or to use estimates 
of these volumes, adding uncertainty to the accuracy of its revenue 
calculations. For example, we examined the production volumes for 8 of 
the 13 leases we reviewed during the 6-month sale and found significant 
discrepancies between these volumes and the volumes in its financial 
database. Similarly, independent auditors performing an audit of MMS's 
fiscal year 2002 financial statements noted that MMS's use of estimated 
volumes did not ensure an accurate calculation of the SPR amounts 
transferred to DOE. Third, we identified some minor discrepancies in 
the prices MMS used to calculate the value of the SPR transfers, such 
as using an index other than that used during the 6-month sale and 
assuming that companies bid exactly the same on the SPR transfers as 
they did in the 6-month sale, but it is unclear as to whether these 
discrepancies would significantly alter MMS's calculations.

Sales of Royalty Gas from Two Pipelines in the Gulf of Mexico Generated 
Higher Revenues Than Would Have Been Expected from Cash Royalties:

After initial experimentation with selling royalty gas in 1995 and 
simultaneously with the contracting of gas marketers in 1999, MMS 
established sales procedures for offshore royalty gas similar to those 
in 2003. Beginning in June 1999, MMS tested the sale of offshore 
royalty gas from 11 federal offshore leases. Production from these 
leases flowed through the Matagorda Offshore Pipeline System or through 
the Blessing Pipeline System.[Footnote 11] MMS entered a cooperative 
agreement with the Texas General Land Office to conduct the RIK sales 
because under section 8(g) of the Outer Continental Shelf Lands Act, 
royalty revenues for federal leases located in coastal waters are to be 
shared with the state. MMS sold the royalty gas for 1-month periods at 
competitive auctions, during which purchasers who met minimum financial 
qualifications bid an increment or decrement relative to applicable 
published gas indexes. Several months into the pilot, MMS started 
dividing the gas into two separate packages--a larger package (base 
volume), for which MMS guaranteed that it would deliver the specified 
volume at a fixed first-of-the-month price, and a smaller package 
(swing volume), for which MMS did not guarantee the volume delivered 
and which MMS offered at published prices that varied daily. Beginning 
in 2000, MMS began combining its monthly gas sales into two sales 
periods for administrative reasons. MMS now conducts gas sales for 
delivery from April through October, corresponding to the period during 
which natural gas is used extensively for air conditioning, and for 
delivery from November through March, corresponding to the period 
during which natural gas is used extensively for heating.

In accordance with its cooperative agreement with the Texas General 
Land Office, MMS issued a draft report in March 2002 on the analysis of 
its gas sales from the Blessing and the Matagorda Offshore Pipeline 
Systems from June 1999 through December 2000. The report stated that 
the RIK sales increased revenues by nearly $1 million over what it 
would have collected in cash royalties--an increase of about 1 percent 
on sales of almost $100 million. MMS obtained this estimate by 
comparing RIK sales revenues to cash royalty sales from 18 other leases 
located in the same geographic area. However, because of limitations 
with its financial data, MMS did not subtract the costs of transporting 
the gas to its sales points onshore, comparing gross unit prices rather 
than prices net of transportation allowances.

After reviewing MMS's study and conducting our own analysis, we reached 
conclusions similar to those of MMS--that revenues from the sale of RIK 
gas from the Blessing and Matagorda Offshore Pipeline Systems were 
higher than MMS would have received in cash royalty payments. We 
included additional RIK leases in our analysis, excluded some cash 
royalty payments that MMS later identified as not coming from leases on 
the same pipeline systems, and extended the time frame of our study to 
December 2001. We estimated that, including the cost to transport the 
RIK gas to its onshore sales points, revenues were increased by about 2 
percent. Hence, we estimate that MMS realized about $4 million more 
than it would have collected in cash royalties, or a gain of about 2 
percent on sales of about $210 million. A more detailed description of 
our analysis appears in appendix I.

Data Limitations Prevent a More Comprehensive Analysis of RIK Sales:

In analyzing RIK sales, we identified specific limitations in MMS's 
financial data that inhibited our analysis and precluded us from 
conducting a comprehensive computer-based assessment of all RIK sales. 
A small amount of erroneous, missing, and improperly coded financial 
data, together with other anomalous but legitimate financial data, 
required time-consuming inspections of these data and complex edit 
checks to ensure data reliability and integrity. For example, in our 
analysis of the three RIK pilot sales, we analyzed almost 60,000 
financial transactions, followed at times by a line-by-line inspection 
of some of these data, discussions with MMS personnel, and manual 
checks of source documents. MMS staff confirmed that the financial data 
in their raw form were unreliable in assessing program performance; in 
some instances, MMS staff chose to use contract prices or production 
volumes in lieu of the financial data because they lacked confidence in 
the available financial data. In addition, the lack of a systematic 
method to electronically combine data in its financial database with 
well, pipeline, product quality, and market center data also prevented 
us from analyzing the revenue impacts of all offshore RIK sales. 
Although MMS obtains and records these data for individual properties 
included in its RIK sales, MMS personnel must manually obtain these 
data for each property through time-consuming phone calls and searches 
of industry databases. According to its procedures, MMS performs these 
data collection efforts each time it expands the RIK program into new 
areas. However, MMS's unsystematic collection and recording of these 
data may slow the development of benchmarks against which to compare 
RIK sales in the future.

In 2001, MMS took steps to improve its collection and management of 
royalty data and to develop the means to identify and correct erroneous 
financial data. For example, MMS began to develop a more consistent 
coding of RIK transactions, and MMS personnel in the RIK Office began 
to take a more active role in entering RIK transactions for the purpose 
of ensuring data reliability. In October 2001, MMS revised its 
electronic form for collecting royalty data in an attempt to correct 
erroneous data. More recently, MMS sought external assistance in 
developing software to identify erroneous data that can then be 
corrected or eliminated. While some of the data problems may have been 
resolved by MMS, other problems continue to be evident. Specifically, 
the misallocation of SPR volumes to some individual leases and the 
aggregating of sales from multiple gas leases will continue to 
complicate future analyses unless these problems are corrected. MMS 
says that it plans to correct these deficiencies as it further refines 
its newly acquired oil and gas information systems. See appendix I for 
more detailed information on data problems.

Lacking Formal Requirements, Many RIK Sales Remain Unanalyzed:

Our ability to assess the revenue impact of RIK sales was further 
limited by the failure of MMS to analyze and document the results of 
its sales. We reported in January 2003 that MMS quantified the revenue 
impacts of only 9 percent of the 15.8 million barrels of federal 
royalty oil that it sold from October 1998 through July 2002 and about 
44 percent of the 241 billion cubic feet of federal royalty gas that it 
sold from December 1998 through March 2002. MMS has since sold an 
additional 201 billion cubic feet of gas in the Gulf of Mexico and an 
additional 1.4 million barrels of oil in Wyoming through November 2003, 
but has not published an analysis of the revenue impacts of these 
sales. In total, we estimate that MMS has analyzed only 8 percent of 
the 17.2 million barrels of royalty oil and 24 percent of the 442 
billion cubic feet of royalty gas sold during RIK pilot sales through 
November 2003. This limited analysis of revenue impacts could be a 
significant issue as RIK sales expand in the future. Based on MMS's 
estimates for further expansion of the program, we estimate that MMS 
could be collecting between $1.5 billion and $2.5 billion per year in 
revenue from the RIK pilot sales by 2008.

MMS has not systematically analyzed and documented the results of all 
its RIK sales for four main reasons. The first and most significant 
reason is that MMS has no requirement that all sales results be 
analyzed and documented. Although the Congress directs MMS to (1) 
obtain fair market value and (2) collect at least as much revenue from 
the RIK sales as MMS would have collected from traditional cash royalty 
payments, MMS is not required to document how this directive is met. 
While MMS does analyze factors that will affect the revenues of 
upcoming sales, MMS lacks a systematic process for analyzing the final 
results of each of its sales. Second, staff responsible for conducting 
sales already believe that they have enough information on sales 
results. For example, MMS staff cited the second 6-month oil sale in 
the Gulf of Mexico in which market conditions unexpectedly moved in a 
manner that resulted in revenue collections that were less for this 
period than what would have been expected from cash royalty 
collections. MMS stated that they had enough information on the market 
conditions that drove the sales results even before completion of the 
6-month sale. Third, insufficient staff is available for analyzing 
sales. We observed that staff who conduct sales are busy with 
identifying properties for inclusion in sales, establishing minimum 
acceptable bids, evaluating bids, and expanding the program. MMS has 
only one staff member independent of the RIK Program whose duties 
involve selectively analyzing RIK sales results at the direction of MMS 
management. To ensure proper management control and to remove the 
appearance of a conflict of interest, it is best to segregate the 
responsibility of a program's operation from the responsibility of 
reviewing the program, which MMS correctly did when it reviewed the 
Wyoming oil and the Gulf of Mexico gas sales. Fourth, a lengthy 
management review process limits the usefulness of analyses that are 
conducted. For example, MMS's report on the Wyoming pilot sales dated 
March 2001 and its report on gas sales in the Gulf of Mexico dated 
March 2002 remained in draft form pending final management approval 
until March 2004. In addition, a study of subsequent gas sales in the 
Gulf of Mexico, completed in April 2003, is still being reviewed and 
modified under the direction of MMS management.

MMS Has Recently Taken Steps to Address Deficiencies in Analyzing Sales 
Results and Quantifying Administrative Efficiency:

Since our last report, MMS has hired an industry consulting group to 
develop a strategic plan to guide the transition of the RIK pilots 
through the end of 2008. MMS intends to develop a 5-year business plan 
based largely upon the consulting group's plan. The consulting group, 
among other things, has proposed that MMS (1) develop benchmarks that 
are indicative of fair market value; (2) develop a consistent process 
for monitoring RIK sales at regular time periods against these 
benchmarks; (3) develop a consistent process for deciding whether to 
accept cash royalty payments or to take RIK; (4) track administrative 
efficiency expressed as the cost per unit of royalty oil and gas sold; 
and (5) measure the amount of time it takes to collect, report, audit, 
and reconcile RIK revenue collections. The consulting group intends 
that the benchmarks satisfy MMS's congressional mandates that RIK sales 
achieve fair market value and generate at least what would have been 
collected in cash royalty payments. The consulting group has developed 
a timetable for MMS to develop benchmarks for fair market value by 
March 2004 and benchmarks for administrative efficiency by March 2005.

While much of the data collection for developing benchmarks will remain 
a manual process, MMS anticipates that overall calculation of RIK 
Program performance will be facilitated by MMS's newly acquired RIK 
information systems. MMS stated that while data on RIK sales are 
available in less than 30 days after the sales month, RIK purchasers 
continue to submit data on quality adjustments and volume imbalances 
after these sales, and MMS must enter these data into its financial 
systems and audit the final figures. MMS believes that 120 days after 
an RIK sale, it will have completed these audits and has set this 120-
day period as a formal objective. Within 180 days, MMS stated that it 
would be able to report on the results of these sales. However, many 
RIK sales only have a length of about 180 days or less, so obtaining 
performance results 180 days after a sale is not timely enough to use 
these results to modify the next sale. Recognizing this limitation, the 
consulting group recommended that performance be measured on a monthly 
or quarterly basis, and MMS believes this will be possible with its 
newly acquired RIK information systems.

Conclusions:

RIK can be an important tool for managing the collection of royalty 
revenues from federal oil and gas leases. In light of the possibility 
of revenue collections from RIK sales approaching $1.5 billion to $2.5 
billion by 2008, it is important that MMS measure and document the 
revenue impact and costs of administering RIK relative to cash royalty 
payments, to ensure itself and the public that royalties are collected 
in the most efficient manner. In doing so, MMS may be able to 
conclusively show that it has reduced overall administrative costs or 
collected more than traditional cash royalty payments. MMS has made 
some progress in analyzing the revenue impacts of some of its sales, 
but many sales remain unanalyzed, and MMS has yet to implement a more 
systematic and timely approach to analyzing these sales. Also, 
completely quantifying the administrative efficiency of these RIK sales 
continues to be a challenge. While key data from MMS's new activity-
based cost management system have shed some light on the difference in 
costs to administer RIK and cash royalties, MMS has been unable to 
quantify any overall benefit that may arise from shifting resources to 
auditing more cash royalty payments and from changes in litigation due 
to RIK. Unless steps are taken to quantify the impacts of these 
changes, MMS and the Congress will be unable to determine the 
efficiency of RIK. Because MMS has not systematically assessed and 
documented the overall administrative cost and revenue impacts of many 
RIK sales, knowledge of MMS's RIK Program is insufficient to determine 
whether MMS should expand or contract the use of RIK.

Matters for Congressional Consideration:

Should the Congress seek a more systematic and timely evaluation of RIK 
efforts, the Congress may want to consider directing MMS to implement a 
systematic process for evaluating all future RIK sales in a timely 
manner and to quantify any changes in the administrative cost and 
revenue impact on royalty collections as a result of RIK.

Agency Comments and Our Evaluation:

We provided the Department of the Interior with a draft of this report 
for review and comment. Interior generally agreed with our observations 
and emphasized the steps that they are taking to improve their 
measurement of RIK sales performance. Interior said that the insights 
and conclusions contained in the report are timely and will be valuable 
in their efforts to improve the RIK Program. Their comments and our 
response to these comments are reproduced in appendix II.

As agreed with your offices, and unless you publicly announce its 
contents earlier, we plan no further distribution of this report until 
30 days from the date of this letter. At that time, we will send copies 
of this report to the Secretary of the Interior; the Director of the 
Office of Management and Budget; and other interested parties. We will 
also make copies available to others upon request. This report will be 
available at no charge on GAO's Web site at [Hyperlink, 
http://www.gao.gov].

If you have any questions about this report, please call Mark Gaffigan 
or me at (202) 512-3841. Key contributors to this report are listed in 
appendix III.

Signed by: 

Jim Wells: 
Director, Natural Resources and Environment:

[End of section]

Appendixes: 

Appendix I: Objectives, Scope, and Methodology:

To determine the administrative cost savings associated with RIK, we 
first examined MMS's two draft studies on RIK sales--Wyoming Oil 
Royalty In Kind Pilot, Evaluation Report (June 1, 2002) and Texas 
General Land Office/Minerals Management Service 8(g) Gas Royalty In-
Kind Pilot, A Report (March 27, 2002). We reviewed MMS's logic and 
assumptions in these reports concerning the quantification of 
administrative savings and benefits attributable to RIK. We used the 
data in these reports, MMS's budgetary data, and testimonial evidence 
from MMS officials to identify which aspects of administrative savings 
and benefits to investigate. We then obtained data from the activity-
based cost (ABC) management system for the entire fiscal year 2003 and 
solicited MMS's assistance in understanding the individual activities 
and in identifying which direct costs were attributable to RIK sales 
and which were attributable to cash royalty collections. We also 
obtained one-time expenditures for MMS's new information systems from 
MMS officials and supporting documentation since not all of these costs 
were reflected in the fiscal year 2003 ABC data. To calculate costs for 
auditing cash royalty payments and RIK sales revenue on a per-lease 
basis, we used ABC data, together with the numbers of the different 
types of leases that MMS audited in fiscal year 2003, as supplied by 
MMS. We obtained data on additional royalty revenue obtained through 
auditing and compliance activities from MMS's report entitled Report of 
Royalty Management and Delinquent Account Collection Activities, Fiscal 
Year 2000. We interviewed MMS personnel on the costs of appeals, and we 
interviewed attorneys in the Department of the Interior's Solicitor's 
Office to obtain information on the impact of RIK sales on litigation. 
Finally, we audited revenue from all RIK sales during fiscal year 2002 
to determine the benefit of early collections.

To evaluate all of MMS's RIK pilot sales, we planned to compare RIK 
sales revenues with cash royalties from comparable federal leases. We 
started with sales in the Gulf of Mexico by attempting to identify 
comparable leases through the electronic matching of attributes, such 
as type of oil, sulfur content, market center, well location, pipeline 
available for shipment, and distance to the nearest market center. To 
do so necessitated combining data on these attributes in MMS's offshore 
geographic information system with data on sales values, sales volumes, 
royalty values, royalty volumes, transportation deductions, and quality 
bank adjustments in MMS's financial system. We examined data from 
January 1997 through July 2003, but we did not independently verify the 
integrity of MMS's financial database. Unfortunately, we could not 
perform the intended analysis because of two reasons: (1) we were 
unable to link the data in the financial system with data in the 
offshore geographic information system, and (2) we identified many data 
anomalies in MMS's financial database. We were unable to link the 
financial data with data in the offshore geographic information system 
because the common link--the lease number--had been compromised during 
some RIK gas sales. Specifically, MMS personnel who entered these data 
had combined RIK sales revenue from multiple leases and entered these 
data under a new lease number referred to as a "dummy lease number." We 
also found that some data that would be helpful in identifying 
comparable oil leases, such as the quality of oil and the sulfur 
content, were not present in MMS's geographic information system. Upon 
examination of the financial data, we discovered many data anomalies 
that prevented us from reliably and easily aggregating the monthly 
transactions to the same lease and payor. Within the data aggregated to 
the month-lease-payor level, anomalies included negative sales volumes, 
missing sales values, negative sales values, and missing quality 
measures for gas prior to fiscal year 2002. Some of these anomalies 
were obvious errors, but many more appeared to be correct and 
legitimate data entries. With no explanations in the financial data 
documentation to indicate which anomalies were accurate and which were 
not, resolving the anomalies required line-by-line inspection of the 
data and, in some cases, manual checks with other documentation. As a 
result of the large number of data anomalies and the time-consuming 
process required to correct and verify the royalty data, we undertook 
case studies of MMS's RIK pilots in three sales areas: (1) RIK oil 
sales in Wyoming, (2) RIK oil sales in the Gulf of Mexico, and (3) RIK 
gas sales on two pipelines in the Gulf of Mexico.

Wyoming Oil:

In analyzing the integrity and reliability of MMS's financial data that 
we used to evaluate RIK oil sales in Wyoming, we selected nine 
properties that provided about 47 percent of the oil sold during the 
RIK sales we analyzed. We selected properties that produced the three 
different types of crude oil that MMS sold in its RIK sales--asphaltic, 
general sour, and Wyoming sweet oils. We obtained MMS's financial data 
for all nine properties from January 1996 through March 2002 and 
aggregated these 32,823 financial transactions to the property-month 
level rather than the lease level because we anticipated that the 
financial impact of the smaller leases would not be as significant. We 
found that 3.3 percent of property months contained erroneous or 
missing data, but we were able to correct or obtain these data.

To estimate the revenue impact of Wyoming RIK oil sales, we attempted 
to determine if Wyoming severance tax[Footnote 12] prices were a good 
proxy for what MMS would have received in cash royalty payments. We 
first obtained the state of Wyoming's severance tax data for the same 
nine properties. We then proceeded to examine the average sales price 
per barrel and the number of barrels produced from each property during 
each of the 33 months immediately preceding the first RIK sale. The 
Bureau of Land Management, which leased the nine federal properties in 
Wyoming, grouped federal leases into these properties based on the 
geological boundaries of the oil fields. Personnel with the state of 
Wyoming, however, group producing leases into clusters for tax 
purposes. At our request, a Wyoming state official attempted to match 
these clusters as closely as possible to the federal properties. 
However, some clusters included additional state or private leases that 
they could not segregate, and in some instances, the state official 
could not precisely match the properties. We then graphed the volumes 
reported to the state of Wyoming for severance taxes and the volumes 
reported to MMS for cash sales for each of the nine properties. The 
graphs suggested that seven state properties contained many of the same 
federal leases. We then graphed the state severance tax prices and 
MMS's cash royalty prices for each property. We determined that the 
severance tax prices and MMS's cash royalty prices are essentially the 
same for eight properties. The severance tax prices for the ninth 
property were on average about 50 cents higher than MMS's cash royalty 
prices. See figures 1, 2, and 3 for graphs of these prices that 
aggregate properties according to type of oil.

Figure 1: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected Asphaltic Properties Subsequently Included in RIK Sales:

[See PDF for image]

[End of figure]

Figure 2: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected General Sour Properties Subsequently Included in RIK Sales:

[See PDF for image]

[End of figure]

Figure 3: Comparison of Weighted Average Monthly Sales Prices Obtained 
from Wyoming Severance Tax Database and MMS's Financial System for 
Selected Sweet Properties Subsequently Included in RIK Sales:

[See PDF for image]

[End of figure]

Gulf of Mexico Oil:

To evaluate the integrity and reliability of MMS's financial data that 
we used to evaluate the second RIK oil sale in the Gulf of Mexico, we 
examined MMS's financial data from January 1997 through March 2002 for 
16 of the 26 leases in the sale. We removed all transactions involving 
the SPR and small refiners so that we could compare sales from the 
second RIK sale to cash royalty payments only. We found this initial 
task difficult because MMS inconsistently used transaction codes for 
sales to small refiners and for transfers to the SPR during the time 
frame of our study. We aggregated 7,725 transactions to the payor-
lease-month level and found that 1.9 percent of the payor-lease-months 
contained erroneous or missing data, and about 9 percent of the 
aggregated data was compromised by payors using multiple payor codes. 
Payors also inconsistently reported or did not report royalty volumes 
when reporting transportation deductions prior to October 2001 and 
inconsistently reported or did not report sales values when reporting 
quality bank adjustments. We subsequently reduced the period of our 
analysis to June 2000 through March 2002, reduced our leases to the 13 
that accounted for about 89 percent of the oil sold during the sale, 
and corrected the single significant error that we found in this data 
set.

To estimate the revenue impact of the October 2001 through March 2002 
RIK oil sale in the Gulf of Mexico, we first chose a sample of leases 
included in the RIK sale and determined the relationship of their cash 
sales prices before the RIK sale to the prices as prescribed by MMS's 
royalty valuation regulations for sales to affiliated companies (also 
known as transactions not at arm's length). We analyzed only those 
leases that produced Mars and Eugene Island sweet oil because these two 
oil grades collectively accounted for 96 percent of the production. We 
then selected only the Mars and Eugene Island leases that had cash 
royalty sales during at least 8 of the 16 months between June 2000--the 
first month that the current oil valuation regulations became 
effective, and September 2001--the month immediately preceding the RIK 
sale. These selection criteria produced the 13 leases for our detailed 
analysis. Eleven of the 13 leases had cash royalty sales during all 16 
months. For each of the 13 leases, we then calculated the average 
monthly cash sales price (net of any transportation allowances and 
quality bank adjustments) from data in MMS's financial database for 
each of the 16 months preceding the RIK sale. Next, we obtained the 
average monthly price from MMS for Mars and Eugene Island sweet oils as 
prescribed in MMS's oil valuation regulations for sales not at arm' 
length at the market center for the same time period. We then 
subtracted these monthly prices from the average monthly cash prices 
and multiplied this difference by the barrels of oil sold each month to 
yield monthly revenue for each lease relative to MMS's regulations. 
Next, we summed these monthly revenues and divided the sum by the total 
barrels of oil sold to obtain a weighted average difference per barrel 
for the entire 16-month period. This value, -$1.36, indicates that MMS 
received on average $1.36 less than the market center price for each 
barrel of royalty oil produced from these 13 leases from June 2000 
through September 2001. We attribute most of this difference to the 
payors' costs of transporting the oil to market. Finally, for the 6-
month term of the RIK sale, we calculated a weighted average difference 
per barrel between the RIK sales price and the price as prescribed by 
MMS's valuation regulations for transactions not at arm's length. This 
value, -$2.24, indicates that MMS received on average $2.24 less than 
the average market center price for each barrel of oil that MMS sold 
during its RIK sale from October 2001 through March 2002. We then 
assumed that if MMS had not conducted this RIK sale, it would have 
received cash royalty payments that on average would have been $1.36 
less than the market center price as we previously computed. We 
subtracted $2.24 from $1.36 to estimate that MMS lost on average $0.88 
on every barrel that MMS sold during this RIK sale. Since MMS sold 8.2 
million barrels during this sale, MMS lost approximately $7.2 million.

Gulf of Mexico Gas:

In analyzing MMS's financial data on gas sales in the Gulf of Mexico, 
we discussed with MMS officials the financial data limitations that 
they identified while conducting their analysis of RIK gas sales--
limitations that prompted MMS personnel to use invoice prices rather 
than the sales data in MMS's financial database. We then obtained 
19,211 financial transactions for all the cash and RIK sales on the 
Blessing and Matagorda Offshore Pipeline Systems (MOPS) from January 
1997 through December 2001. Upon aggregating these data to the payor-
lease-month level and researching anomalous data, we found that 6 
percent of the RIK summary data remained anomalous. Consequently, we 
decided to use the RIK invoice data, adjusted for transportation costs, 
to compute net unit prices for the RIK transactions.

To estimate the revenue impacts of RIK gas sales in the Gulf of Mexico, 
we relied on financial data aggregated to the lease-month for all cash 
sales on the Blessing Pipeline System and on MOPS from January 1997 
through December 2001.[Footnote 13] On each of the pipeline systems, 
MMS determined that the leases from which it received cash royalty 
payments were comparable to the leases from which it collected RIK. For 
each lease connected to the Blessing Pipeline System, we calculated the 
average cash sales price net of all reported transportation costs per 
MMBtu for each month and subtracted it from the average RIK sales price 
net of all transportation costs per MMBtu for each month.[Footnote 14] 
We then multiplied these figures by the quantity of royalty gas (in 
MMBtu) sold in kind each month to obtain the monthly revenue impacts, 
and we then summed the monthly revenue impacts to yield total revenue 
impacts of the RIK sales on the Blessing Pipeline System. To determine 
the revenue impacts of RIK sales on MOPS, we followed the same 
procedure as that on the Blessing Pipeline System, using data specific 
to sales on that pipeline. We then summed the revenue impacts from RIK 
sales on both systems to yield the total estimated revenue gain of 
about $4 million on sales of about $210 million.

Other Factors May Affect Revenue Analysis:

Our case studies did not include other overall factors that may affect 
revenues from RIK sales. First, differences in the timing of royalty 
collections can affect total revenue collections because an earlier 
collection of these revenues allows the Treasury to earn interest on 
the funds collected. Revenues from the sale of royalty oil are due 10 
days earlier than cash royalties, while revenues from the sale of gas 
are due 5 days earlier than cash royalties. We reviewed MMS's revenue 
collections from all RIK pilot sales during fiscal year 2002 and 
determined that 98 percent of the oil and 92 percent of the gas 
revenues were collected according to this early schedule. For fiscal 
year 2002, we calculated the combined benefit to be about $128,500, or 
about 0.03 percent on a total of $454 million collected in RIK pilot 
sales.[Footnote 15] MMS may have also realized relatively small amounts 
of money from interest on those revenues that were late. Future 
benefits will depend upon the amount of oil and gas sold in kind, 
interest rates, and the sales prices of oil and gas. Secondly, during 
the time frame of our revenue analysis, data were not available on a 
lease-by-lease basis that would enable us to estimate how much 
additional revenue had accrued to MMS as the result of the audit 
process. Hence, we could not determine whether any additional funds 
collected as a result of auditing were included in MMS's financial 
data. For example, Wyoming state auditors who audit the federal leases 
in Wyoming that we included in our revenue analysis stated that they 
audited some of these leases for some of the time frame. While any 
additional audit collections would be expected to affect unit prices in 
both MMS's financial database and the state's severance tax database, 
additional collections were not necessarily recorded for every lease. 
We did not examine how any additional collections resulting from audits 
were recorded for oil and gas leases in the Gulf of Mexico because of 
the difficulty in accessing individual leases in the information system 
that tracks auditing efforts. In addition, some of the time frame that 
we included in our revenue analyses had not yet been audited by MMS 
when we initiated our work.

[End of section]

Appendix II: Comments from the Department of the Interior:

United States Department of the Interior:

OFFICE OF THE SECRETARY 
Washington, DC 20240:

TAKE PRIDE IN AMERICA:

APR - 5 2004:

Mr. Jim Wells:

Director, Natural Resources and Environment 
U.S. General Accounting Office:

441 G Street, N.W. - Room 2T23A 
Washington, D.C. 20548:

Dear Mr. Wells:

We appreciate the opportunity to review the U.S. General Accounting 
Office (GAO) Draft Audit Report, MINERAL REVENUES: "Cost and Revenue 
Information Needed to Compare Different Approaches for Collecting 
Federal Oil and Gas Royalties." Our general and specific comments are 
enclosed for you to consider for incorporation into the final report.

The insights and conclusions contained in the draft report are timely 
and will be valuable in our efforts to improve the Federal Royalty-In-
Kind Program. We generally agree with your observations as more fully 
described in the enclosed response.

The Department of the Interior's Minerals Management Service (MMS) has 
been implementing an asset management approach for the collection and 
verification of the Nation's oil and gas mineral royalties. In this 
effort, MMS has implemented a strategic plan to make the royalty-in-
kind (RIK) approach a permanent component of the asset management 
strategy to be used in tandem with the royalty-in-value (RIV) approach. 
We appreciate GAO's acknowledgment of the progress made in advancing 
the RIK approach in the March 2004 draft report.

Again, thank you for the opportunity to review and comment on this 
report. If you have any questions, please contact Ms. Denise Johnson, 
Minerals Management Service's Audit Liaison Officer, at (202) 208-3976.

Sincerely,

Signed for: 

Rebecca W. Watson: 
Assistant Secretary Land and Minerals Management:

Enclosure:

Response to March 2004 General Accounting Office (GAO) Draft Report 
Titled "Cost and Revenue Information Needed to Compare Different 
Approaches for Collecting Federal Oil and Gas Royalties":

Summary Comments:

The March 2004 draft GAO report primarily addresses the administrative 
costs and revenues associated with the MMS royalty-in-kind (RIK) pilot 
projects. The report offers insights and conclusions on the importance 
of performance measures and information needed to comparatively 
evaluate the RIK and royalty-in-value (RIV) approaches. The MMS agrees 
with GAO and has already taken steps to improve RIK performance 
documentation and measurement. As discussed below, we have been 
implementing and will continue to refine implementation of new systems 
and procedures necessary to ensure effective RIK program operations and 
contemporaneous evaluation of program performance.

Since issuance of the January 2003 GAO report, MMS has successfully 
designed and implemented three RIK information systems. All three 
systems, a gas management system, liquids management system, and a Risk 
and Performance Management (RPM) System, were implemented on time and 
within budget. They are the operational backbone of the RIK program, 
housing all transactions and most of the data. As a result, the RIK 
management control process is now functioning on a par with commercial 
industry standards.

The draft report states that limitations in MMS's access to and 
analysis of revenue data prevented a comprehensive GAO assessment of 
RIK sales. The MMS's program experience, combined with initial results 
from new measurement tools, indicates that revenues are generally 
higher and that administrative costs are reduced under the RIK 
approach. The MMS has been awaiting completion of its new automated RIK 
support systems to more fully address the limitations observed by GAO. 
These systems are now implemented and MMS is able to better evaluate 
both revenues and costs to document RIK program performance.

The GAO draft report correctly acknowledges implementation and use of 
an Activity-Based Cost (ABC) Management System to capture cost data and 
allocate to various minerals revenue management functions. The draft 
report also notes that the ABC system has identified substantial audit 
savings in FY 2003. These efficiencies have already freed-up resources 
to conduct additional audits and assist on RIK functions.

GAO's analyses of the revenue impacts of two of the three RIK pilot 
projects assessed in the draft report show revenue gains totaling some 
$5 million. These assessments are consistent with MMS's internal 
analyses of the same pilot projects. The MMS agrees with the GAO 
conclusion that the time period covered in their assessment of the Gulf 
of Mexico crude oil sale is too short for any meaningfully assessment 
of economic results.

The draft report emphasizes the importance of systems and processes for 
measuring both the administrative costs and revenue impacts of the RIK 
program. MMS fully recognizes this responsibility. MMS's monitoring and 
evaluation of the RIK pilot projects has always included in-depth pre-
sale, concurrent, and post-sale analyses of RIK value received. These 
assessments document and assure that the MMS RIK program is complying 
with the underlying statutory obligations authorizing the program.

The MMS agrees with the GAO conclusion that more systematic and timely 
measurement of program performance is needed for the future. The 
recently implemented information systems position MMS to 
contemporaneously and systematically assess the revenue impacts of the 
RIK program. In February 2004, MMS measured revenue impacts for the 
natural gas RIK program and the non-SPR crude oil program in the Gulf 
of Mexico for recent periods. Results are being evaluated and appear to 
be slightly revenue positive. We are now able to measure revenue 
performance of the RIK program in a systematic, timely, and continuing 
manner. The Administration supports the RIK language in the Energy Bill 
which would substantially address the GAO recommendation to institute 
systematic and timely measurement of the RIK program.

The MMS believes that a Federal RIK Program is essential to the 
effective management of the Nation's oil and gas royalty assets. In 
January 2003, MMS competitively awarded a contract to the Lukens Energy 
Group of Houston, Texas, to commercially assess the RIK program, 
recommend improvements (focusing in major part on performance 
measurement tools and metrics), and make recommendations relative to a 
five-year RIK strategic planning initiative. Based on recommendations 
of the Lukens Energy Group and GAO observations, MMS will publish a 
Five-Year RIK Business Plan in May 2004. The Plan will include 
strategic direction, clear goals and objectives linked to statutory 
authorities, and specific management action items to advance RIK 
business activity for 2004-2008.

Detailed Comments:

GAO Highlights Page and Page 1:

The GAO states that MMS collected $4.7 billion in FY 2003. While this 
number is accurate as reflecting a 5-year average annual distribution 
of mineral royalties, the correct number for mineral royalty 
collections for FY 2003 is $5.6 billion.

Pages 2, 3, 4, 8, 23:

The draft report states that neither GAO nor MMS could quantify revenue 
or cost impacts "conclusively," "completely," or "comprehensively." The 
MMS agrees with this assessment, and notes that, due to inherent 
uncertainties, comparisons of "actual" minerals revenue program results 
to "projected" results of mineral revenue programs, whether under the 
RIK or RIV approaches, are unlikely to ever conclusively, completely, 
or comprehensively quantify revenue or cost impacts. On the revenue 
side, estimates of what would have been received in RIV are just that - 
estimates. On the cost side, as GAO points out in the draft report, 
both the RIK and RIV programs are evolving and present moving targets 
for comparative analysis.

Page 3:

The draft report states that MMS would not have incurred an FY 2003 
direct cost of $1.7 million by accepting cash royalty payments. This 
number incorrectly includes $496,000 for auditing and reconciling 
volumes, a function that MMS incurs whether in RIK or RIV status. Thus, 
the correct direct cost incurred by MMS in FY 2003 for RIK is $1.2 
million.

Page 6:

GAO reports on expenditures for RIK systems development and operation, 
but does not mention expenditure of significant funds for systems that 
support financial and compliance activities. We believe that a balanced 
treatment of comparative costs requires mention of system costs for 
both RIK and RIV or neither.

Page 7:

The GAO states that 572 FTE were maintained by MMS from FY 2002 through 
FY 2004. While this number is accurately sourced from MMS budget 
documents, actual employees on board decreased from 602 in FY 2000 to 
558 in FY 2004. While there are several variables accounting for the 
decrease, the administrative ease of RIK is certainly one of the 
primary factors. We recommend that GAO include these numbers in the 
final report.

Also, with regard to administrative savings, we recommend that GAO 
include data on the FTE trends in the compliance and asset management 
(CAM) workforce (primarily an RIV-dedicated activity). Specifically, 
the CAM offices have shown an FTE decrease of 44 from 2002 to 2004, 
with some of this decrease contributing to the RIK FTE increase of 27 
for the same period.

Page 11:

The GAO incorrectly describes the function of the Risk and Performance 
Management (RPM) System (referred to by GAO as the risk management 
information system) as the performance of credit monitoring. The RPM 
actually is the system that supports measurement of revenue performance 
of the RIK program. It was implemented in August 2003, and, in February 
2004, was populated with data and utilized to begin measurement of RIK 
revenue results for the natural gas and small refiner RIK programs for 
periods during 2003. Credit monitoring is supported by MRM's gas and 
liquids management systems.

Page 21:

The GAO incorrectly states that only one staff employee is assigned to 
assessments of RIK revenue performance. In reality, six MRM staff and 
one MRM senior manager, independent of the marketers, have spent major 
portions of their time in the past year dedicated to these assessments. 
In addition, the marketers located in the RIK Front Office have always 
routinely and continually assessed performance results. Further, 
substantial efforts from two contractors have been expended on 
performance assessments and methodology for the past several years:

* In the past year, Lukens Energy Group submitted three reports to MMS 
dedicated to this topic and another two deliverables addressing 
performance metrics. Two contractor staff and one senior manager spent 
the majority of their time on this effort, and:

For more than 2 years, MRM's systems contractor has been designing, 
developing, implementing, and refining a Risk and Performance 
Management System to measure the revenue performance of the RIK 
program.

The GAO has spent a considerable amount of effort in conducting a 
credible analysis of the revenue results of an MMS crude oil RIK sale 
occurring from October 2001 through March 2002. We appreciate the 
effort and believe that the results are parallel with our analysis. We 
have several technical comments on the GAO analysis which we will 
transmit to GAO field staff.

The following are GAO's comments on the Department of the Interior's 
letter dated April 5, 2004.

GAO Comments:

1. We clarified our report to reflect these comments.

2. We included the costs of $496,000 for auditing leases and 
reconciling volumes because MMS reported it as a direct cost of the RIK 
pilot sales, and because it is unknown how many of these leases would 
have been selected for auditing if they had not been in the RIK 
Program.

3. We acknowledge that there are considerable costs for systems that 
support financial and compliance activities. However, the financial 
system supports both the collection of cash royalty payments and RIK 
payments, so its costs are incurred regardless of whether royalties are 
collected in cash or in kind. We acknowledge MMS's observation that the 
compliance system has associated costs and that these costs are 
incurred predominantly with the collection of cash royalties. However, 
it was not our intent to compare systems costs under different methods 
of collecting royalties. We intended only to mention the incremental 
costs associated with collecting royalties in kind because MMS will 
continue to incur costs associated with collecting cash royalty 
payments.

4. We clarified the report by stating that there is only one staff 
independent of the RIK Program whose duties involve analyzing RIK sales 
results. We acknowledge that additional RIK Program staff and managers 
analyze sales results. However, we believe that proper management 
controls require that staff independent of the RIK Program should 
analyze sales results for MMS management. We also acknowledge and state 
in this report that an independent contractor has assisted with 
developing a strategy for analyzing sales. We believe that this is a 
significant step towards comprehensively and systematically analyzing 
RIK sales results.

5. MMS's technical comments on its Gulf oil sale related to two issues: 
(1) removing the effect of quality bank adjustments and (2) the 
validity of extending its analysis for an additional 12 months. Because 
of the variability of quality bank adjustments, MMS stated that it is 
necessary to remove these adjustments before conducting an analysis, 
and MMS believes that it has done so. We acknowledge the variability of 
quality bank adjustments and also note that transportation allowances 
associated with the leases that we reviewed are also variable, albeit 
to a lesser degree. However, when we conducted our analysis, there was 
insufficient data on quality bank adjustments for the time period prior 
to the second RIK sale to effectively remove their effect from our 
analysis. To compensate for the variability of both quality bank 
adjustments and transportation allowances among the 13 leases we 
examined, we chose to establish our relationship between cash royalty 
payments and MMS's royalty valuation regulations for a relatively long 
time period prior to the 6-month RIK sale. We assumed that the effects 
of variability would be minimized over the 16-month period for which we 
established our relationship. Concerning the validity of extending the 
time period of analyzing the Gulf of Mexico oil sale, MMS restated its 
belief that analyzing the transfer of oil to the SPR during the 
subsequent 12 months is a valid technique. We already discussed the 
limitations of using this technique in the report.

[End of section]

Appendix III: GAO Contacts and Staff Acknowledgments:

GAO Contacts:

Jim Wells (202) 512-3841 Mark Gaffigan (202) 512-3168:

Acknowledgments:

In addition to those named above, Ron Belak, Robert Crystal, Art James, 
Lisa Knight, Jonathan McMurray, Franklin Rusco, Dawn Shorey, and Maria 
Vargas made key contributions to this report.

(360304):

FOOTNOTES

[1] U.S. General Accounting Office, Mineral Revenues: A More Systematic 
Evaluation of the Royalty-in-Kind Pilots Is Needed, GAO-03-296 
(Washington, D.C.: Jan. 9, 2003).

[2] The Mineral Leasing Act uses the term "market price" not "fair 
market value." The requirement to obtain market price does not cover 
competitive sales, which by their very nature, provide some protection 
to the federal government.

[3] We relied upon the direct costs identified by MMS--costs that MMS 
defines as directly supporting its mission. We regarded the RIK direct 
costs as being most indicative of the incremental costs to administer 
the RIK pilots. We did not analyze indirect costs--those costs that MMS 
defines as sustaining the organization, normally referred to as 
overhead, including information technology support, general 
management, and general administrative support. Indirect costs are 
allocated back to the mission-supporting activities based on the ratio 
of the labor cost contained in each direct work activity to the total 
labor cost in all direct work activities.

[4] U.S. General Accounting Office, Mineral Revenues: A More Systematic 
Evaluation of the Royalty-in-Kind Pilots is Needed, GAO-03-296 
(Washington, D. C.: Jan. 9, 2003).

[5] Staff independent of the MMS RIK sales staff conducted draft 
studies for 18 months of the Wyoming oil sales and 19 months of the 
Gulf of Mexico gas sales. See Wyoming Oil Royalty In Kind Pilot, 
Evaluation Report (June 1, 2002) and Texas General Land Office/Minerals 
Management Service 8(g) Gas Royalty In Kind Pilot, A Report (March 27, 
2002).

[6] Wyoming participated in all but the first 6-month sale.

[7] A NYMEX futures contract is an agreement through the New York 
Mercantile Exchange for a future purchase or sale of 1,000 barrels of 
sweet crude oil, similar in quality to West Texas Intermediate oil. 
While most NYMEX contracts result in a financial gain or loss, rather 
than the delivery and receipt of oil, parties to the agreement can 
exchange oil at Cushing, Oklahoma, where several oil pipelines 
intersect and where storage facilities exist.

[8] Properties consist of one or more leases. In Wyoming, producing 
properties often contain more than one contiguous lease.

[9] The first sale was automatically extended for another 5 months.

[10] We chose MMS's valuation regulations for transactions not at 
arm's-length for comparison because these regulations rely upon readily 
available published oil prices at market centers through which the oil 
must flow.

[11] Although not technically named the Blessing Pipeline System, GAO 
and MMS refer to it by this name because the pipelines terminate at a 
gas plant in Blessing County, Texas.

[12] Severance taxes are levied by the state as a percentage of the 
value of the oil or gas that is produced, regardless of whether the 
lease is for federal, state, or private lands.

[13] Unlike RIK transactions, data from cash sales could be manually 
reviewed and adjusted to achieve an anomalous financial data rate of 
less than 1 percent.

[14] MMBtu (one million British thermal units) is a measure of the 
heating quality of the gas equal to 1,000 cubic feet of gas at a Btu 
quality of 1,000.

[15] To make this calculation, we used the federal funds rate, which is 
the rate that banks charge each other for short-term loans during the 
Federal Reserve Bank check clearing process. 

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